Capital Structure

05/08/08
Ch. 7

Capital Structure Balance Sheet

 Assets Value of the

Firm


  

Listed by Closeness to Cash Current Assets Long-term Assets Physical and Intangible

 Book Value or historical

value of the assets adjusted for depreciation

 Capital Structure  The borrowed money from the capital markets  Liabilities Fixed claims against the assets  Owners Equity Residual claim against assets  Book Values not Market

Values
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What is Debt?
 Fixed claims against the company, the

liabilities
 

Current Liabilities, accounts payable Long-term Liabilities

 

Bank Loans Bonds

 The borrowed money will be paid back

usually in pre-specified amounts and at prespecified timetemporary funding

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Examples of Debt
 Loans
  

Principal and interest due at maturity Interest as you go, principal at maturity Principal and interest as you go, usually equal payments at equal intervals, annuity Banks Bondholders

 By Lender - 

 Interest portion is usually tax deductible

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What is Equity?
 Value of the company claimed by owners  What is left over after debt claims are

satisfied  Permanent Capital

  

Repayment not required Repayment via dividends Dividends not tax deductible (not an expense of the company)

 Outstanding Common Stock

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Ways to Raise $$$$

 Borrow from suppliers accounts payable  Borrow from bank bank loan  Borrow from bondholders issue bonds  Borrow from other companies sign leases  Borrow from owners
   

Personal funds of founder/owner Issue preferred stock Issue common stock Issue warrants
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Some Hybrid Securities

 Convertible Bonds  Initially issued as two assets, a straight bond and an option to convert to stock  Set conversion ratio  Some protection on the down-side (bonds have fixed repayment)  Potential for up-side, convert to stock if company (stock prices rise)  Preferred Stock  Guaranteed dividends (consol or perpetuity)

Financing Options Tied to Life Cycle

 Life Cycle of a firm
     

Birth (Start-up) Youth (Expansion) Teen-age (Rapid or High Growth) Adult (Mature) Old Age (Decline) Death (Bankruptcy)

 Personal Funds, Angel Funds, Venture

Capitalist, Loans, Public Equity, Bonds

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Raising Equity in Capital Markets

 Usually in late teen early adulthood  Have need for large $$$$  Find Investment Banking Firm Start IPO  File paperwork with SEC  Market Security  Conduct Auction  Distribute Stock and Collect $$$  Subsequent issues are Seasoned Equity

Offerings (SEO)
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Cost of Going Public (IPO)

 Legal Costs Registration and Filing Fees  Payment to Investment Banker Best efforts

or Firm Commitment  Marketing Costs Road Show  Underpricing

  

Why on average are IPOs underpriced? When do marginal clients get a call? Marginal clients know they are marginal

 After sale requirements and options

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Cost of Debt
 Legal Costs Registration and Filing Fees  Payment to Investment Banker  Marketing Costs  Potential Default


 

If bondholders or bank not paid back on time the bondholders or bank can claim the firm Direct bankruptcy costs Indirect bankruptcy costs

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Benefits of Debt
 Discipline Managers reduces free cash flow  Covenants in place to restrict certain types

of behavior  Additional outside validation of management activities and choices

  

Bond rating agencies Bank loan officers Subsequent borrowing

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Company Earnings Reinvested

 Earnings of the company can be reinvested in

the company  What is the cost of reinvesting?  What are the choices with company earnings?
  

Pay it back to ownerslet them invest it where they might Cost should be the opportunity cost to the owners Cost of equity w/o issuance costs
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Optimal Capital Structure

 What combination of borrowing is best?  How do you choose which funds you should use for

financing?
 

Debt vs. Equity vs. Company Earnings How much of each?

 Pecking Order Hypothesis  Static Theory Separation of Investing and

Financing Decisions
 

Modigliani and Miller 1956 &1958 Marginal cost of bankruptcy vs. Marginal benefit of debt to find the lowest cost of capital
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Homework
 Problem #4 Convertible Preferred Stock

(me I will do this one in class)  Problem #5 Debt-Equity Ratio



Missing data, bonds are ten year bonds

 Problem #8 Venture Financing  Problem #9 Venture Financing  Problem #15 Rights Offering  Problem #18 Debt for Stock Swap  Problem #23 Debt & Bankruptcy
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